March 2016

Take a moment to read Einstein’s contribution to the 1939 World’s Fair time-capsule (thanks Brainpickings):

Our time is rich in inventive minds, the inventions of which could facilitate our lives considerably. We are crossing the seas by power and utilize power also in order to relieve humanity from all tiring muscular work. We have learned to fly and we are able to send messages and news without any difficulty over the entire world through electric waves.

However, the production and distribution of commodities is entirely unorganized so that everybody must live in fear of being eliminated from the economic cycle, in this way suffering for the want of everything. Furthermore, people living in different countries kill each other at irregular time intervals, so that also for this reason anyone who thinks about the future must live in fear and terror. This is due to the fact that the intelligence and character of the masses are incomparably lower than the intelligence and character of the few who produce something valuable for the community.

I trust that posterity will read these statements with a feeling of proud and justified superiority.

Aside from end of the second paragraph sounding a little elitist by today’s standards, this could have been written today. More than ever we hope and believe that inventive minds can save us and ‘electric waves’ are everywhere. But at the same time huge swathes of people feel disenfranchised and at risk economically, and we live in fear of terrorists. Remarkable.

That said, it’s clear to me we have seen progress. There’s less and less poverty and number and frequency of wars is decreasing. However, we are some way off being able to feel superior to Einstein’s contemporaries in 1939.

Yesterday Stuart McKnight/Ascendant Corporate Finance published their regular report on activity in the UK venture market. As you can see from the chart above, 534 investments were made in the UK (above £0.5m) beating the previous high of 463, which was set back in 2000 at the height of the dotcom bubble madness. As you can see, our ecosystem has been growing fast since 2011, giving more credence to the notion that we we are finally reaching critical mass.

Whilst deal volume broke records last year, deal value did not. By Ascendant’s numbers, in 2016 £2.6bn was invested in the UK and Ireland, up 76% on the £1.5bn invested in 2014, but still well below the 2000 peak of £3.5bn.

London saw more of the action than other cities with 207 of the 534 deals. Edinburgh was the next biggest city with 25.

It’s also interesting to note that only 19% of the deals were in fintech (21% by value).

It isn’t new news that all net job creation happens in young companies, but it’s interesting to see that it’s been consistently true for 31 years. Expect this phenomenon to become more pronounced as startups form a larger and larger part of the economy.

This is US data (source). Would be interesting to see the same in the UK.

Yesterday Benedict Evans wrote about Disrupting Mobile. He noted how PCs disrupted mainframes and how mobile in turn disrupted PCs, and how in both waves of disruption a massive increase in the size of the ecosystem led to the increases in investment which meant the new paradigm prevailed. Looking forward, pretty soon a high percentage of everyone on the planet will have a smartphone making it hard to see where the next massive increase in ecosystem size will come from. Internet of Things and AR/VR use smartphone components and seem to be more of an extension of the smartphone ecosystem than a replacement.

At the very end of his post Benedict wonders whether AI might be the next wave. It could be ubiquitous and shift our attention away from mobile by making it less relevant, in much the way our phones have shifted our attention from our PCs.

I want to think about that for a second.

Today AI is forming the backbone of an increasing number of services (including a few in our portfolio) but it is working through mobile or the web, not making them irrelevant. For the next little while I see our phones becoming more useful and more central as innovators leverage their sensors and always-on nature to provide us better and better services, many of which will be driven by AI. In this future there’s no ‘iPhone moment’ that heralds in a new era.

Later on services are likely to get sufficiently intelligent that we need less sophisticated phones to interact with them. If interaction is primarily through speaking, and if processing is server side, then the smartphone quickly gets commoditised. In parallel, screens and devices will continue to fall in price leading us to own more of them and be less reliant on a primary smartphone. Extending this trend, computers will eventually become part of the fabric of the clothes we wear and the furniture in our houses and offices. At that point carrying a smartphone becomes less important and our attention has firmly shifted away from mobile.

This is more a vision of ubiquitous computing than AI per se, but AI will be a key enabler. User identification and authentication is another obvious challenge.

Often results are not linear. You get a little bit more mass, and you get a lollapalooza result.

Charlie Munger

Critical mass is a term that gets bandied around a lot in the startup world. A common use case is to describe the point when a company reaches sufficient scale that it achieves profitability. Another is the point where a network or ecosystem has sufficient supply and demand that the user experience starts to work. Most networks crack this chicken and egg problem by using a hack of some kind to get either supply or demand in place. AirBnB famously scraped Craigslist to get their business started and here in London Hailo built a social networking app for cabbies as a way to get drivers on the platform before they had any users.

Without hacks like these networks and ecosystems grow slowly, and that’s what’s happened with the startup ecosystem here in London. There have been many successful government and Brussels sponsored initiatives to help get us towards critical mass, but there’s no getting away from the fact that it takes time to build a startup ecosystem. Silicon Valley got properly started in the 1950s and 1960s whereas we have only been going since the late 1990s.

Inevitably we have been sub-critical mass for much of that time, and it’s been painful. Many of our best entrepreneurs have taken the difficult decision to leave their home country and go to Silicon Valley because the startup ecosystem is stronger (most importantly, because there’s more finance) and the companies that remain have, on average, found it more difficult to raise capital, often resulting in smaller raises, less ambitious plans, and slower growth.

Over the last year or two I’ve felt that changing. It’s not possible to define critical mass and therefore to pinpoint the moment it’s been achieved, but the recent proliferation of new startups and new funds (including ours) feels like Munger’s lollapalooza result. High failure rates are part of the model, so it should never be easy to create a company or build a fund, and that remains the case, but it has definitely got a lot easier recently, at least in part because the volume of investors and high quality founders reached a point where there was lots of opportunity for everybody and confidence spiralled.

The other reason financing companies got easier recently is because the markets were hot last year. They are less hot now. It will be interesting to see if our ecosystem has the depth and resilience to stay at or above critical mass, or whether we will dip back below.

At a conference last week Autodesk CEO Carl Bass said that he thinks about acquisitions in three buckets:

companies that are really people who have a technology that Autodesk wants to build up (acquihires)

middle-size companies, meaning they have product that they’re selling, maybe even internationally

large scale acquisitions

He wants to make lots of acquisitions in the first category, a handful in the second, and only rarely in the third. For context note that Autodesk is a $13bn market cap company, and are thus likely to make fewer large scale acquisitions than much bigger businesses.

This sort of tallies with my experience and what I’ve heard lots of investment bankers say over the years, which is that companies get acquired for up to around $100m without having to show that they are sustainable in the long term. But as deals get bigger analysis of forecasts and the financial impact on the acquirer become much more important.

In terms of Carl Bass’s categorisation, I would say that most acquihires are sub $50m and that middle-sized companies get you up towards the $100m level and maybe a little way beyond.

$10-20m revenues is the threshold for most high growth businesses that gets you into what I would call ‘large scale’ territory of $100m+ exits.

Also very important to note is that the number of acquisitions declines precipitously as the valuation rises.

Finally, a huge caveat, I put these rules and recommendations out there because I think they are a useful guide, but the quality of revenues varies hugely between companies and intellectual property and other elements can also drive valuation. Moreover, much is driven by luck in this industry and individual counter-examples abound..

All this is written primarily with ecommerce, marketplace and software companies in mind.

But once we are all working hard and understand the importance of getting all the small things right it gets more complicated.

Easiest to understand is the excellence of individual things. Products, press releases, processes, new hires, office space – I could go on and on. This is the sort of excellence that Stuart Butterfield was asking his team for back in 2013, just as Slack was launching:

The reason for saying we need to do ‘an exceptional, near-perfect job of execution’ is this: When you want something really bad, you will put up with a lot of flaws. But if you do not yet know you want something, your tolerance will be much lower. That’s why it is especially important for us to build a beautiful, elegant and considerate piece of software. Every bit of grace, refinement, and thoughtfulness on our part will pull people along. Every petty irritation will stop them and give the impression that it is not worth it. …. It is very difficult to approach Slack with beginner’s mind. But we have to, all of us, and we have to do it every day, over and over and polish every rough edge off until this product is as smooth as lacquered mahogany.

As smooth as lacquered mahogany. Wow! Who wouldn’t want to build or use that?

More complicated is the excellence of companies as a whole. Excellent companies are excellent because they make rapid progress, they have excellent things within them, but they have other things that are non-excellent. Every business is a hotch-potch of trade-offs between speed and quallity. The better companies are more successful because they have compromised excellence less, not because they haven’t compromised it at all.

In these three examples management have consciously or unconsciously chosen to focus on their main goal and accept second best in other areas. They did that because it’s the only way to get things done.

The problem is much more acute at small companies with limited resources. There are only so many hours in the day and hard choices need to be made between doing everything to perfection and achieving milestones to secure the next round of funding, or shipping software before customers lose patience.

In practice the trade-off between speed and quality bites with individual decisions like:

Do I hire the great person I’ve just met, or should I run a process to make sure I’ve properly calibrated the market?

Do I hire someone good or do I hold out for someone great, even though the position may be vacant for a year? (that happened to a company we talked about yesterday)

Do I launch today knowing that 2% of customers will experience a product on checkout, or do I wait a week to fix it? (another real example)

Do I spend an extra 2 hours improving my pitch deck, or do I email it now like I said I would?

Do I focus on growth or do I optimise my unit economics?

Startups that make rapid progress take the expedient option some of the time. The art is knowing when to compromise and when to insist on quality. The best founders know what their top priorities are and hold standards in those areas whilst accepting second best in lower priority areas where speed is important.

Last May law firm Fenwick and West published an analysis of the 37 US unicorn deals that happened in the twelve months ending 31st March 2015. It’s an old post which I saw for the first time this morning.

Here’s the headline data on the deals:

Mean valuation: $4.4bn

Median valuation: $1.6bn

35% of companies had valuations in the $1.0-1.1bn range, indicating many companies negotiated specifically to get unicorn status

The headline finding was that the unicorn investors had significantly more downside protection than public market investors. All of the deals had a liquidation preference of 1x or more. This goes some way to explaining why we went through a period when late stage private companies were valued higher than their listed peers. However, whilst I haven’t seen a full analysis, I doubt this additional downside protection would be enough to explain all the difference in valuation. I think a bigger part of the explanation lies in deal dynamics – it’s easier for companies maximise valuation in private financing auctions than it is in IPOs.

However, few of the deals went beyond a simple 1x non-participating preference share. I always wondered if companies were accepting multiple liquidation preferences in exchange for high valuations, but that was only the case in 3% of the deals analysed. Similarly, only 5% of the deals had a participating preference share (in a participating preference share the investor gets their money back first and then participates pro-rata with other shareholders in any remaining proceeds).

Other protections were not that significant in number either. Only 30% of the deals had protection against a downround IPO, and protection against private downrounds was inline with venture industry standards (weighted average anti-dilution protection).

In summary, structuring and other fun and games was limited and the high valuations were pretty much what they appeared to be.

One other interesting titbit is that 75% of the rounds were led by hedge funds, mutual funds, sovereign wealth funds, corporates or other non-traditional investors in private companies. Money from these sources flows quickly in and out of markets and is now chasing other opportunities. It’s that more than anything which has been bringing the market down for the last six months.

Regular readers will know that I’ve been meditating for three years now and it’s an important part of my life. Meditation helps me deal with stress, make better decisions, keep my energy levels up and feel happier. For a while I was a bit of a meditation zealot, but I stopped that because it wasn’t helping people. The learning curve for meditation is too steep and the benefits too unclear for most people to make it a habit. Since then I’ve been looking for ways to make the benefits clearer and the learning curve easier. Headspace and Calm.com are great, but I’m looking for something that goes further.

I was at a breakfast with a group of leaders last week organised by my friend Rohan Narse where we meditated a little and took some time to reflect on where we are with our lives. It was a peaceful yet invigorating experience. Rohan introduced the session with a quote from the philosopher Viktor Frankl:

Between stimulus and response there is a space. In that space is our power to choose our response. In our response lies our growth and our freedom.

Rohan was making the point that the more we learn to pause the more we can take control and exercise our power to choose. A quick focus on the breath, as taught in meditation, is a great way to pause and take control.

There’s a good article on CityAM this morning which talks to this subject. Their point is that by regulating our breathing we can first learn to recognise the emotions we are feeling and then later learn to change the emotions to help us do whatever we are trying to do. The examples they give are the ability to switch from frustration to determination or to conjure up a feelings of excitement or enthusiasm.

They say there are 34,000 distinct emotional states, but if we can start to distinguish as few as fifty on a regular basis then we have the potential to start changing what we feel.

That’s very powerful.

It is for wiser minds than mine to explore, but I’m wondering two things:

if ‘taking a pause’ is an easier way to access the early benefits of meditation than learning to meditate

if learning emotional control is a clear enough benefit that people will find it easier to motivate themselves to build a habit

I like to make an analogy with exercise. Fifty years ago nobody much did exercise and the health benefits weren’t well understood. Now everybody knows the benefits and a large percentage of people have built good exercise habits. I believe that in fifty years time we will be able to say something similar about meditation.

I was at a Draper Esprit investor presentation this morning and CEO Simon Cook quoted Xavier Rolet, CEO of the London Stock Exchange from his recently published report on 1,000 companies to inspire Britain:

We want particularly to shine a light on the companies variously identified as ‘gazelles’, ‘the vital 6%’ or ‘scale-ups,’ which have a remarkably disproportionate impact on UK national economic output. As the CBI recently confirmed, 3,000 scale-up medium-sized businesses contributed £59bn to the UK economy between 2010 and 2013, effectively making the crucial difference between recession and recovery. To put it another way, just a 1% increase in the number of high-growth businesses would create 230,000 new jobs and add £38bn or 2% to UK GDP.

Put another way, the work we are all doing building and investing in high growth companies has a massive positive impact on the UK. That’s the lives of millions of people.

100% of the net new jobs in the US and European economies derive from companies that are less than five years old

This is not a new theme, but it is new information, and I love it. It adds another layer of purpose to what we do.

That said, the data is still a little confusing. The idea that startups make a big difference to economies has been around for maybe ten years now and the statistics and data have got much better in the last two or three, so things are definitely improving. However, when Rolet says that a 1% increase in the number of high growth businesses would create 230,000 new jobs and add £38bn to UK GDP that seems at odds with the CBI data about 3,000 companies contributing £59bn to the economy from 2010-2013. I guess that the 1% must be of a much higher number than 3,000 – otherwise 30 companies need to create an average of 8k jobs each, which sounds like a lot to me. Facebook only has around 13,000.